The Financial Crisis - A Brief Explanation of a Simple Cause

You are a CEO. You're probably in high demand. You get a new gig. Probably comes with a boat-load of stock/stock options, bonus schemes, and high pay. In general, the grandeur of your pay will largely depends on how much you raise EPS and concurrently the stock price. Supposedly, this aligns your incentives with your shareholders. But there are two fundamental and simple points of economics that are generally overlooked. The first is the matter of time horizons. The second is that not all returns are equal. You can't look at return without considering how much risk was taken to achieve those returns. Let me give you two analogies.

You arrive in Vegas with a bag full of other people's money. These people sent you out there because you have a reputation as a wizard gambler. After all, you went out there last year with some of their friends' money and came back with quite a bounty. The deal is simple. They paid for your trip, all expenses, and also gave you a fixed sum of money up front just to go out there. They are also promising you a large percentage of the winnings. Furthermore, they've put a long term contract in front of you to be their official gambler if you come back with substantial winnings. This job will include a very cushy salary, executive residence in Vegas, driver, etc.

As a rational economic agent (not necessarily a moral one), the most logical path is simple. Bet BIG. If you lose, you still walk away with the substantial fixed sum you got up front, and will most likely will still be in high-demand as a whiz gambler in other circles. So you go to the roulette table and wager all your money on black. Bam. It hits black and you've already doubled your investors' (or shall we call them speculators) money. That a 100% return, a large chunk of which is yours. If you were really smart you'd simply enjoy the rest of your time by the pool-side and return home with a nice bag of cash. Yet, you might feel the need to really bring home the purse. So you do it again. BAM. You win again. You've now quadrupled their money.

You return home and are luaded as a real whiz. Many groups of investors now want you to be their gambling pro and start comepting with eachother by throwing ridiculous sums of money and deals at you. You are made for life. The investors don't realize that you've basically just been the beneficiary of dumb luck. In fact, you took outsized risk to achieve those returns. If it all went to hell, you really lose nothing. If you got lucky, you get almost equal benefits to your shareholders. No risk, all return, for you. Pretty much the opposite for those who staked you.

The reality in the corporate world is even worse. In Roulette, if you gambled it all on black and lost, those results are rather immediate. In the corporate world, most CEO's can pursue disastrous policies and yet forestall the consequences for a few years. When the wheel hits red, they'll already be at their next job with a higher salary and a Midas reputation.

Yet, before we put all the blame on CEO's, let's think like a CEO for a minute. Let's look at another scenario.

You've just become CEO of a company that is either flying high or doing poorly. The shareholders and board are on your back. They either want you to turn the ship around or take it to new heights. Moreso, you're competitors have come out with some new products that are just minting money. They want you to get in the game.

You are actually an intelligent and capable CEO, and so you undertake a thorough analysis of what's going on in the market. You realize that recent industry practices are irresponsible and illusory and are no different than betting it all on black. You now have two options:

• Attempt to explain this to your board and shareholders and stay out of the game. Your earnings will probably suffer as compared to your competitors. As their stocks soar to new heights and their management is praised in the media, your stock craters and you and your team are the dogs of the street. The shareholders are up in arms. Their neighbors are driving Ferraris with this new-found wealth and you've sunk their ship. They want you out immediately and they want your head. No golden parachute for you.
• Or you do the same analysis and realize that you are simply that gambler in vegas. If you bet it all, you will probably make tons of money, please your shareholders, and walk out a hero. You assume you'll be out by the time the ship sinks. Even if you're not, your competitors ships will most likely sink simulatenously. You'll all blame the market and the short sellers and walk out with your golden parachutes and reputations for taking your companies to new heights. On to the next job.

Unless you're a masochist, most rational people would choose option 2. Now I'm not trying to say that no CEO's add value, or that they're all adding reward simply by taking risk. I'm just trying to point out that there is an insitutional problem at play here that's much larger than just this credit crisis. It's deeply embedded in the current structure of our entire economy. In the seperation of a centralized and powerful management from dispersed shareholders. In the power of institutional investors who are deeply in cahoots with the very management teams they are supposed to be wary of.

I'm not saying that CEO's are not to blame for choosing option 1. But, we should realize, that the system we all support, the ignorance of financial and mathematical matter that we all embrace, and the blind eye we all turn when it seems that every American might just have a Ferrari one day, are what push that CEO towards option 2.

P.S. - One more point. The CEO's that do choose option 1 probably don't survive for very long in the system. Thus, we end up with option 2 only CEO's. The same can be argued for corporations that forgo profits for moral purposes. In the face of ruthless competitors they simply won't survive and thus we'll only be left with the immoral companies.